What Is Successor Liability and How Can You Avoid It?

What Is Successor Liability and How Can You Avoid It?

When one company wants to acquire another company, there are a number of different legal forms that the acquisition can take. Two of the common methods of acquisition are asset acquisition and a merger. In an asset acquisition, an acquirer purchases the assets of the target company and the target company can continue its separate legal existence while in a merger the target company typically merges with and disappears into the acquiring corporation. While there are a number of issues for an acquirer to consider when deciding on the form of an acquisition, one important consideration is successor liability.

 

Successor liability arises when the acquiring company is liable and responsible for the obligations of the target company such as its contractual obligations. The general rule is that an asset acquisition cuts off successor liability, while a merger results in the successor entity assuming the liabilities of the target company. However, as is so often the case, there are exceptions to the general rule that an asset acquisition cuts off successor liability. This blog post provides a summary of the most common exceptions. Each state has its own rules regarding successor liability, but many common themes are found across the various jurisdictions.

 

There are four traditional exceptions to the defense of successor liability in asset acquisitions that are widely recognized. As typically formulated, those exceptions are that the purchaser does not assume the seller’s liabilities unless (1) there is an express or implied agreement of assumption, (2) the transaction amounts to a consolidation or merger of the two corporations, (3) the purchasing corporation is a mere continuation of the seller, or (4) the transfer of assets to the purchaser is for the fraudulent purpose of escaping liability for the seller’s debts.

 

The first exception to the defense of successor liability is that a successor corporation may expressly agree to assume liabilities from the target company in an asset acquisition. In those cases, the successor company will be liable to the extent of its agreement to do so. In the “consolidation or merger” exception, liability will be transferred to the purchaser when the purchaser pays for the target company’s assets with its stock. In those situations, the owners of the selling corporation become owners of the purchasing corporation when the transaction closes. In the fraud exception, courts reserve the discretion to look past the formal structure of a transaction to determine whether the real purpose of the transaction was simply to avoid liabilities and not a bona fide sale of corporate assets for legitimate business purposes.

 

In the “mere continuation exception, ” the California Supreme Court has stated a corporation acquiring the assets of another corporation is the latter’s mere continuation and therefore liable for its debts only upon a showing of one or both of the following factual elements: (1) no adequate consideration was given for the predecessor corporation’s assets and made available for meeting the claims of its unsecured creditors; or (2) one or more persons were officers, directors, or stockholders of both corporations. While the mere continuation test might appear on its face to describe a wide swathe of asset acquisitions, in practice courts have required plaintiffs to clear a high bar before imposing liability on the successor. Generally, a plaintiff will have to show that it is fair and equitable to deviate from the general rule and for the purchaser to bear the successor’s liabilities. This is most easily shown when there is continuity of ownership between the seller and the purchaser. However, courts have emphasized that all the facts and circumstances of an acquisition must be examined and no single factor will be determinative.

 

In addition to the four traditional exceptions to the successor liability defense in asset acquisitions, there are three other exceptions that apply in a narrower set of circumstances and jurisdictions. We will cover those exceptions in another blog post.